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De-jargoned: Sortino ratio

LiveMint 16-06-2014Lisa Pallavi Barbora

It is well known that investing in risky assets is not just about return but you also have to keep track of the risk. Leaving aside the risk of the underlying company or business you invest in, the foremost risk investors face is price volatility. Volatility is the daily change in price that a listed security undergoes and this change over a period of time determines an investor’s return.

The Sortino ratio is a formula used to measure the risk-adjusted returns of a portfolio. It is a modification made to the more commonly used Sharpe ratio, which considers overall volatility versus returns. However, Sortino ratio only takes into account the downside volatility of returns rather than total volatility.

How is it calculated?

Sortino ratio comprises of two parts. The numerator is calculated as the difference between the portfolio return or the return of a mutual fund for a given period and the risk-free rate of return for that period. This part is the one that represents the return of a portfolio. The risk-free rate of return can be the return on any benchmark security, usually a government security. The denominator is the downside standard deviation of returns. This part represents the risk of the portfolio.

Standard deviation of returns shows how much daily returns vary from the average of the period. Higher the standard deviation the more volatile are the returns considered to be. Similarly, a downside standard deviation measures only the volatility of negative returns. Once again, the lower this ratio, the better it is.

The downside deviation is divided by the portfolio’s excess return, which gives us the Sortino ratio.

Why is this used?

While volatility considers both upside and downside movement, investors are less concerned about the positive volatility or the frequent changes in prices when they are moving up.

Unlike the Sharpe ratio (also used to measure risk adjusted returns), this formula does not punish the fund manager for positive volatility and only measures the return versus the volatility or risk of negative returns.

If you are going to measure risk over large periods and take into account returns over periods of longer frequency (for example, annual returns rather than daily returns), the Sortino ratio may not be that effective. This happens because for some securities over large periods, the volatility of returns is low and hence, there isn’t enough data.

In general, this ratio should be used alongside the Sharpe ratio. It is more effective in comparing highly volatile portfolios over shorter periods of time. But both the Sharpe and Sortino ratios are important tools to measure the risk-adjusted returns of a portfolio like mutual funds.

Similar to Sharpe ratio, there is is no specific level to watch out for as far as Sortino ratio is concerned. It is used to compare risk-adjusted returns among several portfolios; the higher it is the better.